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Swaps: Introduction. Swaps. Interest Rate Swaps Plain Vanilla Cash Flows Structure Revaluation. Plain Vanilla Swaps. Fixed Interest Payments for Floating Interest Payments Swap Buyer is Fixed Rate Payor
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Swaps • Interest Rate Swaps • Plain Vanilla • Cash Flows • Structure • Revaluation
Plain Vanilla Swaps • Fixed Interest Payments for Floating Interest Payments • Swap Buyer is Fixed Rate Payor • Assume 4 year swap of 10% fixed rate payments vs. unknown LIBOR on $100,000,000 notional principal (NP). Note, no payments up front or terminally. Only NET interest payments between parties.
Plain Vanilla Swap • Payments are: LIBOR rates: 9.5, 10.5, 9 and 10.5 Time LIBOR Pymt $ Pymt Diff. 1 $9.5 million $10Mill -500K 2 $10.5 million $10Mill +500K 3 $9.0 million $10Mill -1Mill 4 $ 10.5 million $10Mill +500K
Point of Plain Vanilla Swap • Without adjustment to existing securities, Floating became Fixed, and Fixed became Floating. Floating ID’d at start of each period! • Lower Transaction Costs. • Ability to Activate Perceptions: • Fixed wants to be Floating if rates are falling. • Floating wants to be Fixed if rates are rising.
Structuring a Swap • Observe interest rates on yield curve: 10% Interest Rate 8% 1 year 6 month
Forward Rates • Rate of 6-month loan in 6 months (6-month FRA, termed a 6x12). • A 1-year rate must be equivalent to 6-month rate combined with 6x12 rate. • (1 + 0R12) = (1+ ½0R6)(1+ ½6R12) • Thus, price 6x12 off of known 6 & 12 month rates.
Structuring a Swap • (1 + 0R12) = (1+ ½0R6)(1+ ½6R12) • (1+.10) = (1 + ½ (.08)) * (1 + ½ (6R12)) • 6R12 = [(1.10/1.04) – 1] * 2 = 11.54% • Floating CFs as a % of any face amount will be: • 6-month: .08 * ½ = .04 1-year: .1154 * ½ = .0577
Structuring a Swap • Fixed Payments are where: (.04 – Fixed) (.0577 – Fixed) • 0 = -------------------- + ----------------------- (1 + ½ (.08)) (1.10) • Fixed = .0486 9.72% Fixed (annual)
Now 6mo 1yr Swap Structure(on $100M in Notional Prin.) $0.91M Pymt From Fixed to Fltg $4M $5.77M $4.86M $4.86M $0.86M Pymt From Fltg to Fixed -$0.85M / (1.04) + $0.91M / (1.10) = 0
Swap Revaluation(Marking-to-Market) • What if rates jumped 1% next day? (6-month=9%, 1-year=11%) • (1 + 0R12) = (1+ ½0R6)(1+ ½6R12) • (1+.11) = (1 + ½ (.09)) * (1 + ½ (6R12)) • 6R12 = [(1.11/1.045) – 1] * 2 = 12.44% • 1-yr CF now .1244*½ = .0622
Now 6mo 1yr Swap Revaluation $1.36M Pymt From Fixed to Fltg (on $100M NP) 6-month CF does not change as determined at swap origination $4M $6.22M $4.86M $4.86M $0.86M Pymt From Fltg to Fixed -$0.85M / (1.045) + $1.36M / (1.11) = $0.40M Gain to Fixed Rate Payor